The Role of Public Financial Institutions in Reducing CO2 Emissions and  Countries’ Vulnerability to Climate Risks

Large-scale public interventions are needed to address climate change and to fund low-carbon and resilient development. The financing gap for the energy transition is major; the IEA estimates that financing the energy transition requires as much as $2 trillion (current levels are around $900 billion) invested annually this decade, and $4 trillion annual investment from 2030 (IEA, 2021, 2022). Beyond energy investment, finance is urgently needed for other aspects of climate mitigation and adaptation, particularly for developing countries. Public financial institutions (PFIs), as government-backed entities with official mandates to serve public policy objectives, are crucial investors in facilitating and mobilising such funds for tackling climate change. Since PFIs are public institutions, there is more space for them to be used as atypical climate policy instruments by governments, providing authorities with an interesting avenue for climate action, on top of more traditional policies (such as e.g., subsidies, emissions trading schemes, carbon taxes). However, there is scant academic research on PFIs’ climate actions and impacts, particularly for extensive samples.

Since PFIs can be used to help mobilise the enormous amounts of funds required to bring about climate transition and to facilitate climate-resilient development, it is imperative to empirically investigate the presence and significance of PFIs in the financial system and how they engage with climate change. Examining how this potential role for PFIs can be leveraged to address the climate crisis was the focus of my recently accepted doctoral thesis. Through my research, I examine the landscape of PFIs in the financial system, looking not only at those with a pronounced climate orientation (e.g., public climate funds and green banks) but also at development financial institutions, public banks and state-owned investors that mainly provide conventional financing. Among the 789 PFIs domiciled in Germany, Japan, the UK and the US, that I studied, a textual analysis of these PFIs’ reports found only a modest climate focus, suggesting that the potential for these institutions to finance the transition remains untapped. I argue that to unlock this potential, it is necessary to offer appropriate guidance and regulations that enable the effective use of these resources.

Yet many PFIs do allocate funding to climate finance, and my research also aimed to study how effective that finance is in meeting the recipient countries’ mitigation and adaptation needs, focusing particularly on multilateral development banks (MDBs). The needs-based allocative efficiency of MDB climate finance is estimated with data envelopment analysis (DEA). By assuming the climate finance allocation is in proportion with the country’s CO2 emissions and vulnerability level, DEA analysis yields a set of efficiency scores: a country that received a higher volume of climate finance (output of MDBs’ allocation decision) with a given level of CO2 emissions and vulnerability (input of MDBs’ allocation decision) has a higher efficiency score. The results reveal that currently, MDB climate finance prioritises mitigation over adaptation and concentrates in a small number of relatively wealthy countries. Adaptation projects face more barriers than mitigation projects to access fundings from the private sector and extremely rely on public financing. Following the current allocation that prioritising mitigation may pose significant risks, particularly for the most vulnerable countries. Therefore, I examine the long-term climate consequences of rebalancing the distribution of MDBs’ mitigation and adaptation finance by predicting future emissions and vulnerability under different allocation scenarios. The prediction is based on the association between countries’ CO2 emissions and received mitigation finance and the association between the vulnerability index and received adaptation finance using historical data. With numerical simulation, a more equitable allocation between mitigation and adaptation (from 70:30 to 40:60) could substantially reduce global climate vulnerability, benefiting an additional 1.9 billion people, without significantly altering the annualised growth rate of emissions.  Adaptation is not only to protect against the unfolding negative climate impacts but also to avoid long-term damage to vulnerable communities and ecosystems. Similarly, mitigation is important to achieve the objectives of the Paris Agreement to avoid exacerbating vulnerabilities. This research highlights the importance of PFIs achieving a more balanced allocation between mitigation and adaptation, considering the dimensions of human health and well-being.

Furthermore, I explore the interaction between PFIs and emissions in the context of different stages of economic development and financial development. Using the latest dataset on public development banks from Peking University, I gauge the share of PFIs in the economic (PFIs’ assets to GDP) and financial systems (PFIs’ assets to banks’ assets) of 111 countries. Through cross-sectional regression analysis, I aim to ascertain whether the differences in the share of PFIs explain variations in CO2 emissions across countries. I first incorporate the interaction term of PFIs and financial development into regression, which allows me to examine whether the influence of PFIs on CO2 emissions varies based on the level of the country’s financial development. Additionally, I conduct separate regressions for high-income countries and middle- to low-income countries to accommodate their differing economic development contexts. The regression results show distinct patterns between high-income countries and middle- and low-income countries. In high-income countries, PFIs contribute to a significant reduction in CO2 emissions growth, but this impact is moderated by financial development. This indicates that financial development may introduce alternative factors that offset the positive influence of PFIs on emission reduction efforts. However, CO2 emissions tend to increase with a higher share of PFIs in middle- and low-income countries. This positive impact of PFIs weakens and can even become negative when financial development improves, suggesting that with enhanced financial infrastructure, PFIs may pivot their focus towards funding mitigation. PFIs can play a dual role: funding fossil fuels that produce significant emissions and funding low-carbon technologies and infrastructure to mitigate emissions. This research emphasizes such complex relationships between PFIs, financial development, economic development, and CO2 emissions. Shifting PFIs’ investments away from carbon-intensive sectors, especially in middle- and low-income countries, is crucial for fostering low-carbon and sustainable growth. This is not only because PFIs are obligated to operate in the public interest, but also due to the risks of stranded investments in fossil fuels in the future economic growth.

A major step towards bridging the significant climate finance gap is to first create an inventory of all potential funding sources and the scope of their operations. I focus on a group of crucial but understudied financial agents, public financial institutions. My research presents a comprehensive exploration of various PFIs and their multifaceted role in reducing CO2 emissions and countries’ vulnerability to climate risks. It provides policymakers with new insights concerning the diverse array of public resources managed by PFIs and their potential in addressing climate change. It highlights the imperative of crafting context-sensitive policies and regulations to leverage PFIs’ resources to fund the climate transition in an effective and efficient manner. It is important to note that relying solely on funds from PFIs will not be sufficient to address climate change. PFIs have limits on their funds and need to allocate limited resources among different policy priorities. The climate change challenge goes beyond PFIs’ capacity and is a joint task for both public and private financial intermediaries. In light of this, it is imperative to have a comprehensive investigation of the interplay between PFIs and private investors, which motivates the future research agenda.

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